Understanding bond index funds

Immerse yourself in the Monevatorarchives (hey, it’s what Saturday nights were made for), and you’ll notice we talk a lot about investing in shares. Much less so about bonds.

Bonds – aka fixed income – are the unglamorous siblings to equities1. Yet whilst shares hog the limelight like a first child, you’ll be hard-pressed to find anyone – outside of the gold, guns and baked beans brigade – who say bonds have no part to play in a diversified investment portfolio.

Clearly bonds deserve more love – or at least another lengthy and excessively detailed Monevator article!

In this post we’ll dive into the nuances of the different bond funds out there, to help you find the right one for you.

Characteristics of bonds

Just like their equity equivalents, bond funds have their own special characteristics. As ever with investing, understanding these differences means more jargon to get to grips with.

Aggregate bond funds contain a mix of both government and corporate bonds. (Inflation-linked bonds are usually excluded from aggregate bond funds, and from all but dedicated inflation-linked bond funds).

Duration

Duration is the measure of sensitivity of the price of a bond to a change in interest rates.

Longer-term bonds have greater interest rate risk. That is, if interest rates go up their price falls, and vice versa.

Bonds are typically separated into Ultra-Short (no, not a bond superhero, but bonds with maturities less than a year), Short (a few years), Intermediates (around two to ten years) and Long (10 to 15 years or more).

Lars Kroijer has already covered the importance of duration and short vs long-term bonds in a previous Monevator piece. Check it out to get the low-down.

Credit Risk

Another key characteristic of bond funds is credit risk: How likely is the issuer to not pay you?

We can use credit ratings from the credit rating agencies as a proxy for credit risk.

Bond funds mostly invest in bonds divvied up into four main tranches of credit risk:

Investment grade – BBB or better, investment grade bonds are considered unlikely to default and so are held in large amounts by institutional investors and pension funds.

Sub-investment grade – Bonds issued by countries or companies that are looking a little ropey and could go pop. Excuse the technical jargon.

Mixed – An assortment of investment and sub-investment grade bonds.

Geography

Bond funds can also be split by geography. These range from Country-specific funds (such as UK or US) through regions (Europe, Asia) to Global funds.

Yield

Some bond funds specifically target high-yielding securities. Such bonds will typically be a mixture of high credit risk and/or long duration issues.

Goin’ shopping

Enough of the preamble. Let’s look at how we can passively invest in bonds.

To do so, we need to know what indices contain which types of bonds. As we go through some of the common indices, we will point out some examples of bond index funds that track them.

Aggregate indices

Let’s start off with Aggregate indices. The big cheese of the Aggregates is the Bloomberg Barclays Aggregate Bond Index (or affectionately known as the ‘Agg’).3

The Agg is a conventional government and corporate bond index. It does not include inflation-linked bonds. The underlying bonds must also be investment grade, which rules out low credit quality bonds.

There are different Aggs at the Global, Regional, and Country level.

At the Global level is the Bloomberg Barclays Global Aggregate Bond Index. This index has over 20,000 bonds. To put this into perspective, the equity-equivalent FTSE All-World index has merely 8,000 or so stocks. An example of a fund that tracks the Global Agg is the Vanguard Global Bond Index Fund.4

The Global index has a number of sub-indices, which track different maturities, credit ratings or particular characteristics (such as ESG-weighted).

As mentioned above, there are also Aggregate indices for specific regions and countries. The most prominent example is the US Aggregate Index. An example of a fund that tracks this index is the iShares US Aggregate Bond ETF (Ticker: IUAA).

As far as I’m aware there aren’t any index trackers that follow the UK Aggregate Index.5

Government bond indices

Next up are the government bond indices. Again at the Global level we have offerings from Bloomberg Barclays. We also have a few other indices that track different geographies.

For example, Citibank produce indices that track Developed and G7 markets6. The latter index is tracked by iShares Global Government Bond ETF (Ticker: SGLO).

We also have indices for the gilts market. For example, there is the Bloomberg Barclays Gilt Index – tracked by the Vanguard UK Government Bond ETF (Ticker: VGOV) – and the FTSE Actuaries UK Conventional All stocks. An example fund tracking this index is the iShares Core UK Gilts ETF (Ticker: IGLT).

As with the Aggregate indices, there are also sub-indices that focus on different levels of maturities and credit risks.

Corporate bond indices

Similar to their sovereign counterparts, there are the full range of Bloomberg Barclays Corporate bond indices. These range from Global through to Country-specific level.

There are a few other corporate bond index providers out there. Chief among them is iBoxx, which a number of iShares ETFs and the L&G Sterling Corporate Bond Index Fund track.7

Inflation-linked indices

At the global level there is – surprise surprise – a Bloomberg Barclays Inflation-linked index. This is tracked by Xtrackers’ Global Inflation-linked Bond ETF (Ticker: XGIG).

At the UK level there is the Bloomberg Barclays UK Inflation-linked Gilt index. This is followed by a Vanguard fund of the same name.8

As with conventional gilts, there’s also a FTSE Actuaries Inflation-linked Index. This is tracked by the Lyxor FTSE Actuaries UK Gilts Inflation-linked ETF (Ticker: GILI).

Emerging market indices

Interested in the emerging markets? You’ll find a number of different bond indices, from Bloomberg Barclays, FTSE, Bank of America, Merrill Lynch, and JP Morgan.

As with emerging markets equity funds, it’s particularly important to look under the tin of emerging market bond funds to see what they hold. That’s because the definition of what is an ‘emerging market’ differs significantly from provider to provider.

Finally, there are a range of High Yield indices that specifically cover high yielding bonds. Such bonds tend to have lower credit ratings (usually sub-investment grade) and potentially offer the opportunity of higher returns, at the cost of higher risk and volatility.

Get ’em cheap

Very handily, Monevator scribe The Accumulator maintains a list of low-cost index trackers, including bond trackers. Have a peruse at your leisure. If you know of any good ones he’s not covered, please tell us about them in the comments.

Other factors to consider when choosing a bond fund

Before we jump the gun and start throwing our money into the market there are a few other factors to consider when choosing the right bond fund.

Currency hedging

When buying foreign denominated bonds without hedging you are taking on additional currency risk. Currency volatility can swamp the returns and volatility of bonds.

We can see this in the following two charts from Vanguard:

Source: Vanguard

Source: Vanguard

As we can see in the charts above, currency hedging reduces the volatility of bond returns. In addition, it has the effect of leveling the returns of bonds from different countries.

It is important to consider what risks we want take on when investing in bonds. If our aim is to get specific exposure to the potential risks and rewards of bonds – typically to diversify our portfolios, and to dampen volatility – then it is wise to strip out the extra risk from movements in currencies.

If you want to invest in international bonds, it is therefore worth thinking about whether you want to hedge your portfolio against swings in the global currency markets.

Market exposures

Each index and associated tracker exposes you to different markets, in different ways. It’s not going to be easy as an amateur investor to have a very informed view on such exposures, which is one reason why it’s usually best to stick to broad bond markets (and arguably just to government and perhaps investment grade bonds from the UK if you live in Britain). Remember bonds are mostly there in your portfolio for security, not return.

By way of example, let’s think about the Global Aggregate index and compare it to a similar index of shares.

When you invest in a fund that tracks a global market-weighted equity index, you are buying exposure to shares of the world’s most valuable companies (such as Amazon, Google and Apple).

In contrast, with market-weighted bond funds, you buy the most bonds from the most indebted countries (or, if you prefer the sound of it, the biggest issuers). This means loading up on bonds from countries like Japan, Italy, and Spain. It also means you get more corporate bonds from more indebted companies.

You can avoid being overweight a particular country or issuer by plumping for a ‘capped’ index. This is where the weight of any one issuer (or issue) is capped at a set amount.

Credit and duration risk

A third factor to bear in mind is the substantial differences in credit and duration risk between the different sub-classes of bond indices.

For example, UK gilts tend to have very long duration compared to government bonds of other countries. This means that they come with higher interest rate risk.

Similarly, many indices are investment grade only. They exclude bonds from high credit risk issuers, which should reduce volatility but could also exclude you from earning higher returns.

Float-adjusted indices

You might need to consider whether you should plump for a float-adjusted index. These indices account for the fact that central banks are often the largest buyer of government bonds.

For instance, a float-adjusted US Aggregate index excludes bonds held in the vaults of the Federal Reserve.9

Given the impact of Quantitative Easing over the past few years – which has seen central banks invest enormous sums in government bonds – the difference can be quite substantial.

Taking Vanguard as an example, most of its index funds and ETFs track float-adjusted indices. This has the effect of increasing the proportion of corporate bonds relative to government bonds in the Vanguard funds.

Heresy! Consider an active fund

I’ll whisper this bit in case The Accumulator hears me. With bond investing it can sometimes pay to go active.10

Sometimes the bond fund that seems right for you might have a specific profile that’s not achievable through an index fund. You might want to avoid certain countries or duration, or you may be looking to target high yield bonds. A combination of these requirements might make an actively-managed fund more suitable.

It’s worth keeping in mind that most of the returns on bond portfolios are explained by duration and credit risk.

Where there is more leeway (in the broader global indices) managers can tailor their exposure to these risks. For example a manager might underweight Japanese Government bonds or overweight short duration bonds.

As with investing in other assets, it’s important to work out what you need from your bond allocation first and then find the product that best fits.

Don’t neglect to consider costs! In today’s lower return world, the fees of an active bond manager could well gobble up a large percentage of your bond fund’s expected return.

Rounding up

Bonds are an important asset class. We tend not to talk or think about them enough.

Bonds can act as a diversifier and a de-risker to an investment portfolio, so it’s worth considering whether an allocation to bonds can help you meet your investment goals.

Hopefully this article has set out some of the factors to think about when investing in bond index funds and pointed you towards the options available.

If you have any tips of your own when it comes to passive bond investing, please do share them in the comments below!

Read all The Detail Man’s posts on Monevator, and check out his own blog at Young FI Guywhere he talks about life as a financially free twenty-something.

‘Equities’ is just a fancier word for shares.

Unless they are sub-prime mortgage backed securities in 2007!

The Aggs date back many decades and were originally run by Lehman Brothers. In 2008 something bad happened to Lehman and Barclays took over. In 2016 Bloomberg started looking after the indices.

To be precise it tracks the float-adjusted index variant. More on that further on in this article.

If any of our savvy readers can correct me, please do!

Canada, France, Germany, Italy, Japan, United Kingdom, and United States.

These track the iBoxx Sterling Non-Gilts ex-BBB Index.

Specifically, it tracks the float-adjusted index variant.

I know they’re not actually held in vaults, but it’s boring to say ‘held in their electronic accounts’

Actually The Accumulator has also considered active funds before in the bond space.

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